Steve Hamilton is a Tampa native and a graduate of the University of South Florida and the University of Missouri. He now lives in northern Kentucky. A career CPA, Steve has extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.

Sunday, May 20, 2018

Blowing Up An IRA

I am not a
fan of using retirement funds to address day-to-day financial stresses.

That is not
to downplay financial stresses; it is instead to point out that using
retirement funds too easily can open yet another set of problems.

Those who have
followed me for a while know that I disapprove of using retirement funds to
start a business: the so-called Rollovers as Business Startups, whose humorous
acronym is ROBS. I know that – in a seminar setting – it is possible to mitigate
the tax risks that ROBS pose. I do not however practice in a seminar setting.
Heck, I am lucky if a client calls in advance to discuss whatever he/she is getting
ready to do.

Let me give
you a couple of ROBS pitfalls:

(1)You have your IRA buy a fourplex. You
spend time cleaning, doing maintenance and repairs and routinely running to
Home Depot.

Question: Is there a tax
risk here?

(2)You have your IRA buy a business. You
have your son and daughter run the business. You work there part-time and draw
a paycheck.

Question: Is there a tax risk here?

The answer
to both is yes. Consider:

(1)You are buying stuff at Home Depot, stuff
that the IRA should have been buying - as the IRA owns the fourplex, not you. If
you are over age 50, you can contribute $6,500 to the IRA annually. Say that you
have already written that check for the year. You are now overfunding the IRA
every time you go to Home Depot. Granted, one trip is not a big deal, but make routine
trips – or incur a major repair – and the facts change. That triggers a 6%
penalty – every year - until you take the money back out.

(2)There are restrictions on direct and
indirect benefits from an IRA. You are receiving a paycheck from an asset the
IRA owns. While arguable, I am confident that your paycheck is a prohibited
benefit.

I am looking
a Tax Court case where the taxpayer had her IRA lend $40,000 to her dad in 2005.
A few years went by and she had the IRA lend $60,000 to a friend.

In 2013 she changed
IRA custodians. The new custodian saw those two loans, and she had problems. Perhaps
the custodian could not transfer the promissory notes. Perhaps there were no notes.
Perhaps the custodian realized that a loan to one’s dad is not allowed. This part
of the case is not clear.

COMMENT: It
is possible to have an IRA lend money. I have a client who does so on a regular
basis. Think however of acting like a bank, with due diligence, promissory
notes, periodic interest and lending to nonrelated independent third-parties.

The IRS saw
easy money:

(1)There was a taxable distribution in 2013;

(2)… and a 10% penalty for early distribution;

(3)… and the “substantial understatement” penalty
because the tax numbers changed enough to rise to the level of “substantial.”

How do you
think it turned out for our tax protagonist?

Go back to the
dates.

She loaned money
to her dad in 2005.

Let’s glance
over IRC Section 408(e)(2)

(2) Loss of exemption of
account where employee engages in prohibited transaction.

(A) In general. If,
during any taxable year of the individual for whose benefit any individual
retirement account is established, that individual or his beneficiary engages
in any transaction prohibited by section 4975 with
respect to such account, such account ceases to be an individual retirement
account as of the first day of such taxable year.

The loan was
a prohibited transaction. She blew up her IRA as of January 1, 2005. This means
that she should have reported ALL of her IRA as taxable income in 2005, of which
we can be quite sure she did not.

Can the IRS assess
taxes for 2005?

Nope. Too
many years have gone by. The standard statute of limitations for assessments is
three years.

So, the IRS
will tag her in 2013, right?

Nope, they
cannot. For one thing, the prohibited transaction did not occur in 2013, and
the IRS is not allowed to time-travel just because it serves their purpose.

But there is
a bigger reason. Read the last part of Sec 408(e)(2) again.

There was no
IRA in 2013. There could be no distribution, no 10% penalty, none of that, as “that”
would require the existence of an IRA.

About Me

Thirty years years in tax practice. It's a long time, and I have seen virtually everything short of the fabled tax-exempt unicorn. I was raised in Tampa, went to school in Missouri, taught at Eastern Kentucky University, lived in Georgia, got pulled to Cincinnati when I married, have in-laws in England and a daughter going to the University of Tennessee. I am not sure where I will wind up next, but I hope there is better weather.